The last 3 years have been excellent for global equities, the UK FTSE All-Share up by 25%, MSCI World up by over 50% and the US tech-laden NASDAQ up by 110%. This period includes the start of the COVID period in early 2020 when markets fell dramatically, the recovery in the second half of 2020 and 2021, as well as the recent market correction. The strong performance was driven by low interest rates, as well as the enormous amount of monetary and fiscal stimulus on the part of central banks and governments around the world. In addition, there was a focus on the use of technology during the COVID lockdowns, which resulted in an acceleration of trends already established towards the digital economy and benefitting technology companies. Markets also pivoted towards ‘ESG’ factors (environmental considerations, social responsibility and good corporate governance) on the basis of the threat of adverse climate change, as well as wider ethical concerns. Companies with good ESG scores attracted witnessed unprecedented demand from investors as a result.
Inflation Surges with Upward Pressure on Interest Rates
The last couple of months of 2021 saw an uptick in volatility as the mood music in markets changed, which has continued into 2022. After years of both inflation and interest rates reducing and remaining very low, inflationary pressures surged and as a result there is upward pressure on interest rates to contain inflation. Inflation has been caused by a surge in demand for goods and services and a lack of supply and capacity in the system after the COVID lockdowns. In addition, environmental pressures regarding climate change have led to a lack of investment in new oil and gas exploration which has resulted in a lack of capacity in the energy sector as renewables are not yet able to meet the demand.
Interest rates were increased in December in the UK which marked a policy shift towards ending more than a decade of loose monetary policy after the financial crash of 2008-9. Markets are anticipating interest rates to climb from 0.25% to around 1%-1.5% in the UK in 2022 and for there to be potentially four or five increases in interest rates in the US this year. Mr Powell, Chairman of the US Federal Reserve stated this week that he will be guided by the data and he would be ‘humble and nimble’ in respect of any decisions regarding interest rates. The expectation is for inflation to peak in the late Spring and then to moderate and reduce for the remainder of year and in 2023 settle at a level close to central bank targets.
Technology Company Valuations Reduced by Surging Inflation
Interest rates matter for equities, especially technology and growth focused companies which tend to re-invest their profits and pay low or no dividends. This is because equities are valued on the basis of the expectation of their future cash flows – and if interest rates are likely to be higher in future, then the value of these future cash flows is subject to a larger discount.
Consequently, since the start of 2022 the US NASDAQ has reduced by around 13%, more than the reduction in global equity markets of around 7.5%. These average market figures hide much larger reductions for many growth businesses, with large companies such as Netflix down around 40% and Tesla, Moderna, Twitter and Salesforce more than 20%. It is notable that other risk assets have also suffered large reductions, such as cryptocurrency, meme stocks, Spacs, plant-based meat and cannabis companies.
Geopolitical concerns are also weighing on market sentiment. In particular, the growing crisis in the Ukraine with large numbers of Russian troops camped on the border, potentially threatening an invasion. NATO appears divided with Germany unwilling to co-operate with the transport of weapons to aid Ukraine. The situation is made more complex by German and Western Europe’s dependence on gas supplied by Russia, especially during the winter. On the other side of the world, tensions have increased between the US and China, particularly in respect of Taiwan and Hong Kong.
Market Volatility as Central Banks Withdraw Support
Central banks have provided a crutch for markets in recent years which has capped volatility; whenever markets have struggled, fresh stimulus has been injected producing another upward wave. Central banks are now pulling back from their support of markets and are likely to seek to reduce the size of balance sheets in the coming years. This should be viewed in a positive light – the global economy is robust enough to stand on its own feet, plus a reversion to normal economics and managing debt is sensible in the long term (the US Fed has a balance sheet currently of approx. $9tn). Labour markets are robust too, which gives confidence about the future trajectory of business performance.
However, the corollary of this is higher levels of volatility in markets and some pain as this market normalisation plays out. It may also depress returns in the short term as bubbles in certain parts of the market deflate. The risks which market face are centred on the risk of policy mistakes by central banks as they walk the tightrope of containing inflation on the one hand, whilst maintaining market confidence and economic growth on the other hand. The stakes have been raised much higher by more than a decade of very cheap money which has fuelled bubbles in almost all assets (bonds, equities and property for instance) with nowhere for investors to go as holding cash or safe government bonds produce returns significantly less than inflation.
Growth and Technology Companies Well Positioned to Prosper
However, we remain optimistic and positive about the outlook for markets over the medium term. Although interest rates will rise, they are likely to remain low by historical standards due to powerful technological and demographic factors (ageing populations save for their retirement and technology and innovation is disinflationary); this continues to be a supportive environment for equities. As noted above, we expect both interest rate and inflation pressures to moderate later this year once supply and demand rebalance in the global economy.
We continue to favour companies innovating in the digital economy as well as green energy. Over time these companies should outperform based on high levels of expected growth and the unprecedented demand for companies engaged combatting climate change and the inexorable transition to a digital economy (how we live, work, shop and relax has changed and continues to shift). This week for example, Apple reported strong results buoying its shares by 7% showing that it could continue to deliver profits even with coronavirus-related semiconductor supply chain issues.
Furthermore, with around a third of US S&P500 companies having reported Q4 2021 earnings at the time of writing, corporate results overall are robust – 77% have exceeded forecasts which is slightly ahead of the 5-year average of 76%, 4% are in-line with forecasts and 19% below forecasts. Most encouragingly, 93% of results to date have exceeded expectations in the technology sector, 3% in-line with forecasts and only 4% below forecast – this continues to support our view than over the medium and longer term the technology sector will drive wider equity market performance.
Please note, our Market Overview & Outlook is our view of markets and does not constitute investment advice. Past performance is not necessarily an indication of future returns; the value of investments and any income from them is not guaranteed and can fall as well as rise. Overseas investments are affected by currency movements and exchange rates. If you would like investment advice on your individual circumstances, please do not hesitate to get in touch, telephone 01392 875500, info@SeabrookClark.co.uk